Deferring COD Income: Burden May Outweigh Benefit

The
election provided in the American Recovery and Reinvestment Act of
2009 (ARRA) to defer until 2014 and spread over five years
cancellation of debt income (CODI) has been touted as an attractive
relief option for taxpayers struggling with cash flow problems.
However, partnerships and S corporations and their owners should
weigh against that potential tax benefit complex recordkeeping and
reporting requirements that can arise, especially in the case of
partial elections and the provision’s interaction with exclusions
for bankruptcy and insolvency.

The
election is available for CODI resulting from the reacquisition in
2009 and 2010 tax years of applicable debt instruments. An
applicable debt instrument is one issued by a C corporation or any
other person in connection with a trade or business conducted by
that person (IRC § 108(i)(3)). For prior JofA coverage, see
“Tax
Consequences of Mortgage Discharge,” Nov. 2009, page 54.

SOLOMONIC
WISDOM REQUIRED

The
bankruptcy or insolvency exclusion is determined at the partner or
shareholder level (section 108(d)(6)), whereas the deferral election
is made at the partnership or S corporation level (section
108(i)(5)(B)(iii)). An example of a simple partnership containing
only two limited partners, one of whom is bankrupt and one of whom
is solvent, illustrates the potential conflict. The insolvent or
bankrupt partner would want to rely on the exclusion, whereas the
solvent partner would want to rely on the new election to effectuate
the deferral. Since the deferral trumps the exclusion, the partners
would be placed in an adversarial position, and the general or tax
matters partner of that partnership would be faced with a task
requiring the wisdom of Solomon.

This
and other points are addressed in the statute and guidance,
including temporary and proposed regulations issued Aug. 11, 2010
(TD 9498 and REG-144762-09; see “Tax
Matters: COD Income Deferral Regs Issued,” page 66). The
electing partnership must first allocate all of the CODI to partners
in the partnership immediately before the debt cancellation in the
manner in which the income would be included in their distributive
shares without regard to section 108(i). The partnership may elect a
full or partial deferral of CODI under section 108(i). The
partnership may then determine by any manner how much of each
partner’s allocable share of the CODI represents a portion of the
deferred amount and how much is taken into account for the tax year
of the debt reacquisition. In other words, for each qualifying debt
reacquisition, each partner may be allotted a portion of deferred
income up to the amount of that partner’s share of CODI and the
partnership’s aggregate section 108(i) deferral for that
reacquisition. See Temp. Treas. Reg. § 1.108(i)-2T.

In
the simple example above, the partnership could elect to defer 50%
of the CODI and report as income the other 50%. The deferred amount
could be allocated to the solvent partner, allowing that partner to
defer the income until 2014 and recognize it ratably over the next
five years, while currently recognized income could be allocated to
the insolvent partner, who may rely on the bankruptcy or insolvency exclusion.

ISSUES
OF SCALE

The
further problem is that not all partnerships are as small and as
simple as the above example. Consider a large national partnership
with diverse partners who are strangers to each other, and whose
financial conditions are not readily known. In addition to the
complexity of determining each partner’s preferences for allocating
a partial deferral, voluminous disclosures and statements must be
distributed to them with Schedule K-1 and attached to their returns.
See sections 4.05 and 4.07 of Revenue Procedure 2009-37 (2009-36 IRB
309) for the lengthy list of required disclosures.

Moreover,
these disclosures must be made every year, from the year of the
election through the final recognition year of 2018. Partners are
also required to report the basis of their partnership interest in
order for the general partner to properly compute the deferred
section 752 amount (increase or decrease in partner’s share of liabilities).

Before
making a section 108(i) election, the partnership must make
reasonable efforts to obtain a written statement signed under
penalty of perjury from each partner with a deferred amount for
which it does not have the information necessary to compute the
partner’s basis in its partnership interest (and its deferred
section 752 amount as described in the revenue procedure).Within 30
days of the date of request by the partnership, each partner with a
deferred amount must provide this written statement to the
partnership. Many partners may lack sufficient information and may
be hesitant to comply. A partner’s failure to comply with this
reporting requirement does not automatically invalidate the
partnership’s election, provided the partnership makes reasonable
efforts before making the section 108(i) election to obtain the
written statement from the partner and otherwise complies with the
requirements of the revenue procedure. If an error is made,
revisions will be necessary.

The
requirements for S corporations are less onerous, requiring only
that a list of shareholders at the time of the election be disclosed
and that the allocation of the deferral be made in accordance with
their ownership interests immediately before the debt reacquisition.
Such disclosure is also required through the final date of income
recognition (2018). The revenue procedure also allows for protective
elections in the event that taxpayers are not clear whether a
transaction has resulted in CODI. Such a protective election is made
with the original federal income tax return for the year in which
the recognition transaction occurs, and again for each subsequent
year for the entire deferral period. The statement must be labeled
as a “section 108(i) protective election,” and provide the
information required by the revenue procedure, including, but not
limited to, the name and tax identification number of the debt
issuer, a description of the debt, the taxpayer’s trade or business,
and a description of the reacquisition transaction.

Another
layer of complication ensues if an electing partnership or S
corporation (or partner or shareholder) then experiences an
“acceleration event” of section 108(i)(5)(D)(ii), including the
sale, exchange or redemption of an interest in a partnership or S
corporation, causing immediate recognition of any remaining deferred
CODI (see also TD 9497 and REG-142800-09).

The
ARRA deferral shows how a seemingly straightforward benefit may be
entirely offset by the complex interaction of onerous reporting
requirements and other tax provisions. General partners and tax
matters partners may be subject to increased personal liability and
the threat of litigation due to the conflicting interests of the
partners and the reporting requirements. Whether they make the
election or not, partnerships may find the rules problematic and burdensome.

TAX NEWS

President Barack Obama signed legislation that retroactively extended more than 50 expired tax provisions for 2014, allowing taxpayers to take advantage of a host of tax incentives during this filing season.

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